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How is 2018 Shaping Up?

How is 2018 Shaping Up?

Guest Post - Monday, November 13, 2017

We know it’s early, but market hopes and dreams have already moved on to next year.

The key item from a macro perspective is has been focused on the success of U.S. tax reform legislation. It's difficult to provide too much clarity here, due to the back-and-forth nature of the negotiations thus far and changing probabilities for success as handicapped by both economists and Washington political consultants. At this point, the odds seem to be slightly above 50/50 for some type of tax cut and/or deeper reform, although the effective date has also been pushed back and forth between 2018 and 2019. Interestingly, the initial tax draft is aimed primarily at cutting corporate taxes to 20% (or thereabouts), while the complicated mix of other tax items has a far less dramatic impact on middle class Americans. In some assumptions, the features the potential of actually increasing taxes for that group. With a groundswell of populist sentiment, not unrelated to the election of Trump in the first place, this element of the bill has naturally been less popular on a grass-roots level. From a practical investment standpoint, however, lowering corporate tax rates increases net profits/earnings, which supports the case for higher prices in equities. This is why markets are focused on the issue, and the impact could be sizeable. So, despite above-average valuations for U.S. equities at this point in time, some of that valuation premium certainly includes optimism about stronger earnings from tax savings (on the flip side, this could mean that uncertainty or hurdles around the tax process could weigh heavily on equity prices and increase volatility if things don't go as planned). Otherwise, earnings growth is still positive, in the upper single digits to near +10% year-over-year, which is a tailwind for stocks.

Bonds are simpler beasts, although the nature of their return drivers is far from simple. Short rates have risen, along with Fed interest rate policy moves. Chances of another hike in December are high, and the base case calls for several increases next year. This would elevate cash and short-term bond rates nearer to 'normal' after a decade of near-zero levels, a situation that has frustrated savers and retirees with larger allocations to that cash/bond segment. After-inflation 'real' rates, however, which have traditionally been positive, could remain very low, even after rate hikes. Intermediate- and long-term bond yields are largely anchored to inflation expectations—which remain tempered at or below the Fed's 2% target, despite expectations by some economists for an eventual inflation pick-up coinciding with wage increases (neither of which have gained traction yet). But, the shape of the yield curve also plays a role, and higher short rates have a lifting effect on longer-rates in normal environment. Based on the timing and magnitude, owners of new bonds earn higher interest as this occurs, but existing bonds could suffer, particularly on the long end of the yield curve.

Credit spreads continue to inch tighter for both investment-grade bonds and lower-quality high yield debt. While fundamental credit conditions are strong, with low current default rates, corporate leverage has increased in recent years along with corporate risk-taking activity. This is in addition to continued investor appetite for yield, which has fueled demand for bonds with any type of yield premium. Credit conditions almost always reach a point of maximum optimism, after which spreads widen and credit no longer looks as attractive. That moment is always difficult to time, but can coincide with and exacerbate recession risks.

Economies abroad began to pick up after the U.S., so their business cycles are also operating at a lag, which is more typical than not, actually. Abroad, in both developed and emerging markets, realized economic and earnings growth have been improving, as are expectations for the coming several years. However, a variety of risks remain, such as populist rhetoric in Europe, the workout details of Brexit and, in emerging markets, slowing and normalizing Chinese growth. These are all weighing on the minds of investors, and explain some of the remaining valuation discounts. Foreign bonds from the largest issuers, such as Europe and Japan, continue to offer extremely low yields, which renders their return potential quite low (as in a half-percent for the coming ten years). Instead, while yields remain higher in emerging market debt, the global reach for yield has also raised valuations and tightened spreads, creating more fickleness in opportunities.

In short, after years of being coordinated during the financial crisis years, the global economic cycle has again diverged. This is a positive from a diversification standpoint, as this type of divergence could mean lower correlations between portfolio asset classes. This is helpful as certain assets become more expensive, while others look more reasonable—particularly the case now outside of the U.S. On the practical side, risk asset volatility as measured by the VIX has been running far below average, and probabilities suggest a drift upward back to average at some point. Chances of a recession look to remain low currently, but the longer that an economic cycle runs and conditions improve, room for error slips and those probabilities begin to increase at some point. In spite of careful Fed policy, downturns are part of the natural economic landscape and can't be avoided.

One can only forecast so much for a coming year or beyond, but a divergence of conditions is generally better news for investors than when many asset classes are synchronized (as we saw during the financial crisis years). While widely-publicized forecasts for a variety of asset classes have been lowered for the next 5-10 years, there is, of course, no silver bullet that looks to provide a better option than a well-constructed asset allocation portfolio.

Read our Weekly Review for November 13, 2017.

Read the previous Question of the Week for October 2, 2017.

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